Professional Incentives

As a society, we tolerate a myriad of conflicts of interest as a matter of common practice. For many professions, these conflicts are simply accepted as the industry standard. I'm not going to suggest a lack of ethics exist in these cases, but clearly the incentives many professions are asked to respond to are not healthy and work against the public's interest.

Let's start with one that nearly everyone can pile on to. In May it was announced that the ratings agency Moody's was under investigation from the SEC for its role in the credit crisis. Moody's is one of the organizations that gave Collateralized Debt Obligations, and their nasty spawn the Credit Default Swap, ratings as high as some government bonds, even though they were comprised mostly of junk. The rub here is that these rating agencies were paid for their ratings by the investment banks that produced the securities. Where did their loyalties lie?

Their service is to rate securities as accurately as possible and the long-term value of their company is tied to their independence and accuracy. But when their day-to-day revenue stream is tied to a) the number of securities they can rate, and b) payments from the investment banks whose securities they are rating, their short-term incentives can create conflicts. If a particular rating agency is more rigorous in their approach, it is not difficult to imagine investment banks seeking the ratings of alternative agencies for most of their products.

Let us look at another profession closer to the Strong Towns realm: engineers. Local governments rely heavily on the advice of these professionals, especially small towns that lack professional capacity on staff.

While some of the work done by engineers is compensated on an hourly fee-per-service basis, much more of it is done as a percentage of the total contract costs. The large revenue streams for engineering firms that work with municipalities come when a project occurs.

This is common sense. When there is a project, you are going to pay your professionals more than when there is no project. Where the conflict comes in is how these projects are assembled and the incentives that accompany them.

For engineers, fees on large projects are generally a percentage of the total cost. In other words, the highest compensation comes with the biggest projects. Right or wrong, this creates a direct incentive to create the biggest possible project in terms of cost. Let's look at two specific examples.

First, we have written a few posts on the Tower Historic Harbor Renaissance project. The $9 million project would create a new city just outside the existing city limits by dredging out the river to form a harbor and then installing new infrastructure to serve it. The premise is that this will boost private sector development. Our suggestion was that they instead focus on getting a higher rate of return out of their existing infrastructure investments, which they can obviously do with no additional cost.

If you are an engineer for Tower, here is roughly what you are looking at for compensation with these two different approaches:

Historic Harbor Renaissance Project, Engineer: $1.3 million (15%)

Strong Towns recommendation for Harbor, Engineer: $0

Second, let's examine the ongoing conversation we have had about roads and streets. Back in January we compared the recommended street sections of my hometowns of Brainerd and Baxter with those recommended in the SmartCode. We showed how a more sensible approach would reduce road construction costs by 43%. Guess what would also thereby be reduced? Professional fees.

Now let's be clear; the professional recommendations to proceed with the Tower project are based on a model of growth and development that you find all over the landscape. These engineers are doing nothing wrong, unethical or immoral by working on this project. The same goes with the street sections. These are industry norms. No engineer can be accused of impropriety by following this recommendation.

Here's the problem: we're not in a era when we need more of the same. We need change and innovation. These old ways of thinking have put us in the position we are in now. We are overbuilt, not underfunded, and we are getting a terrible return on our public investments. More of the same is simply digging the hole deeper.

By professionally intertwining the perpetuation of our current growth pattern with their own financial gain, engineers have compromised their ability to lead us. How can you reform a system to be more cost effective when you have a direct financial incentive to make things more expensive?

We are not putting the financial advisors at Moody's in charge of reforming the financial system. If engineers wish to avoid the same professional fate, they need to come to grips with the fact that they are a big part of the problem, at least before the rest of the public does.

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